The safety of promised benefits is a significant issue in the Social Security reform debate. In a defined contribution system, this issue is particularly important, because the ultimate retirement benefit depends on the value of an individual’s portfolio. The 2001 President’s Commission to Strengthen Social Security recognized the costs and uncertainty inherent in providing guarantees. While acknowledging the role that guarantees may play, the Commission did not include guarantees as part of any of its proposals. And even though future Social Security benefits are not guaranteed, the cost of these guarantees has become an additional obstacle that individual account proposals must now address. The Commission’s report points out that both the Congressional Budget Office and the General Accounting Office call for any government guarantee to be priced and its budgetary effects made explicit.

The market solution for the current Social Security problem does involve risk, but this risk must be weighed against those inherent in Social Security’s current pay-as-you-go financing. A public pension system is always exposed to political risks. If the current system is maintained, scheduled benefits may be paid to future retirees, but, the tax rates necessary to fund them must rise from their current levels, producing lower implied rates of return for future retirees. However, if government attempts to balance the system’s finances with older retirement ages, lower replacement rates, changed cost of living indexing, higher taxation of benefits and the like, it becomes clear that Social Security benefits are not truly guaranteed.

With a PRA system in place, guarantees could be provided in several ways, each with different costs. Downside risk protection, in which currently scheduled benefits are guaranteed as a minimum, with the retiree keeping any upside gains, would be the most expensive of the guarantees usually proposed. An alternative is a pension collar in which returns above a threshold amount are used to finance the cost of the guarantee. And a similar concept is an insurance fund that collects “excess accumulations” to pay for shortfalls in years in which portfolio accumulations fall below a particular level. Each type of guarantee has incentives that will lead workers to choose different risk exposure than they might without those guarantees.

We have opted to guarantee that an individual who participates in the labor force for 35 years will never have a retirement pension that falls below 150 percent of the poverty level. Our plan also implicitly guarantees that during the transition, the reformed defined benefit portion of the program would be paid from tax revenues, just as current Social Security benefits are paid through tax revenues.